Conservative super approach might benefit young

Default funds are in the spotlight as a key part of superannuation funds’ business models but another default – the default investment strategy for most fund members – is more important over the long term.

Many super funds are in the midst of agonising debates about what to do about their basic investment strategy as most medium- and some long-term average investment returns have lagged – and in many cases have failed to achieve the funds’ target returns to earn a margin above inflation.

In the debate, some argue it’s time for funds to rethink their long-term asset allocations and adopt shorter-term, tactical settings. Others claim returns eventually should revert to their long-term trends, making switching unnecessary.

In theory, funds which offer a choice of investment approaches need not worry but the majority of members don’t actively exercise investment choice and so trustees are under an obligation to do the best they can for most members.

The question of default strategies comes into more focus when members are approaching retirement. Australian average default strategies are more heavily skewed to equities than most comparable pension systems.

This wasn’t a problem when sharemarkets were producing high returns but recent volatility and low returns have put question marks over this traditional approach.

With most retirement products largely tied to the sharemarket, there also has been debate about lifestyle or target date funds where the asset mix is adjusted in line with members’ assumed risk tolerance based largely on their age.

One lesson from overseas is that thinking about default investment strategies isn’t necessarily set in stone.

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For instance, there is an almost universal view that young workers’ savings can be exposed to the sharemarkets – based on the theory that young people have time to recover from losses in volatile markets and thus can take the risks and be rewarded with the higher returns.

But this approach has been rejected by the British government’s new National Employment Savings Trust. NEST has decided to reverse traditional thinking and start young members in a conservative portfolio until they pass the age of 29.

NEST has been several years in the making after it was first proposed by the Labour government in 2006, modelled largely on our own multi-employer funds.

It will automatically enrol workers in a pension scheme (unless they opt out) when their employer doesn’t have a pension fund.

Employees will contribute 4 per cent a year, along with 3 per cent from employers and 1 per cent in tax relief. Because workers will have considerable skin in the game, NEST’s approach is not to expose new members to volatile returns or sour their initial savings experience.

This is not that different from some of the initial investment strategies adopted by the fledgling local industry funds when they were established in the mid-1980s.

In contrast to the now more robust approach with high proportions of equities, some industry funds based their early portfolios on capital guaranteed funds offered by the powerful mutual life offices.

This wasn’t merely caution; the big life offices were competing to offer the best capital guaranteed returns and many early industry funds happily took double-digit returns on such products.

With a lot of talk about flexible asset allocations in the debate about life cycle investing, the UK approach is a reminder that sometimes fund trustees might need to consider factors other than pure investment theory in their policies.

For instance, with very low initial account balances in NEST (or, indeed, in accounts of young local workers) the impact on investment returns in the first years of saving and investment may be negligible, especially if equity markets are volatile and producing losses.

In effect, the UK policy makes a trade-off in ensuring confidence among young, initial fund members against the theory of taking high risks early in the saving process.

The policy can switch later when fund members are more comfortable or when equity markets start showing signs of stability and recovery.

The NEST approach is another example of how super funds may look towards a new, more flexible investment strategy matched to members’ desires, needs or comfort levels.